Dr. Coibion on Low Interest Rates

Thu, February 7, 2013

One of the defining features of the current economic crisis has been the zero bound on nominal interest rates. With standard monetary policy running out of ammunition in the midst of one of the sharpest downturns in post-World War II economic history, some prominent economists have suggested that central banks should consider allowing for higher target inflation rates than might have been considered reasonable just a few years ago (e.g. Olivier Blanchard, Paul Krugman, Ken Rogoff and Greg Mankiw). Central bankers in the U.S. and Europe, on the other hand, have so far rejected this suggestion. Higher inflation rates would imply higher nominal interest rates and therefore more scope for countercyclical monetary policy in the face of large negative shocks to the economy such as those experienced in 2007 and 2008 without resorting to unorthodox monetary policy actions (such as quantitative easing) whose effects are poorly understood. But inflation has costs which must be borne even in non-crisis periods, so evaluating the pros and cons of higher inflation targets requires balancing the costs of inflation in all periods against the occasional (but potentially large) benefits it provides during severe economic crises.

In a recent paper, my coauthors (Yuriy Gorodnichenko of UC Berkeley and Johannes Wieland of UC San Diego) and I tackle this problem head on by building a model to quantify both the costs and benefits of higher inflation targets.[1] In our model, higher inflation is costly for several reasons. First, in the presence of infrequent price changes on the part of firms, higher inflation generates an increasing dispersion in prices which leads to a more inefficient allocation of resources among firms. Second, higher inflation also implies more inflation volatility, which is itself costly. Third, higher inflation makes a given level of inflation volatility more costly to households. Offsetting these costs of inflation is the fact that higher inflation reduces the frequency of hitting the zero bound on nominal interest rates. Because the zero bound induces a deflationary mechanism in the economy, these episodes have very large welfare costs.

When the model is calibrated to broadly match the moments of macroeconomic series and the historical incidence of hitting the zero lower bound in the U.S., the optimal inflation rate that balances these costs and benefits is quite low (typically less than two percent per year) and in line with the official inflation targets of the US Federal Reserve and the European Central Bank. The key intuition behind the low optimal inflation rate is that, even though hitting the zero bound on interest rates is very costly (for example a two-year period of zero interest rates has a cost equivalent to a 6.2% permanent reduction in consumption, above and beyond the usual business cycle cost), such events are also rare. In contrast, the costs of inflation must be borne every period, so even modest costs of inflation imply an optimal inflation rate below 2%.

We conclude that raising the target rate of inflation is likely too blunt an instrument to reduce the incidence and severity of zero-bound episodes. Instead, changes in the monetary policy rule, such as price or nominal income targeting, are likely to be more effective both in avoiding and minimizing the costs associated with large economic downturns. In the absence of such a change in the design and implementation of monetary policy, addressing the large welfare losses associated with zero-bound episodes is likely to best be pursued through policies targeted specifically to these episodes, such as countercyclical fiscal policy or the use of non-standard monetary policy tools.